Tuesday, November 3, 2009

Gold is in the news today, setting a new all-time high of $1085/oz. as of this writing. The first chart here shows nominal prices, while the second shows gold in constant dollar (real) prices. Either way you look at it, gold has enjoyed a pretty spectacular run since early 2001. At the risk of slighting the obvious geopolitical risks that motivate gold buyers these days, gold has for the most part benefited from years of accommodative monetary policy from almost all of the world's central banks. Easy money helped inflate the housing bubble several years ago by keeping rates artificially low. Easy money works by effectively lowering the hurdle rate for purchasing hard assets. People must always ask themselves this key question before buying gold, commodities, or real estate: "Will gold (or oil, or copper, etc.) prices in the future rise by more than the interest rate on safe assets?" The lower the interest rate, the easier it is to answer in the affirmative.

Easy money thus erodes the demand for money and boosts the demand for hard assets, resulting in rising tangible asset prices. Money loses its value relative to things, and that's what inflation is all about.

Rising gold prices are thus a signal that interest rates are too low and monetary policy too easy. There is more money in the system than the system wants, and that is the fundamental monetarist equation for inflation. That we haven't seen inflation show up in the CPI (well, at least not very much so far) is simply a reflection of the long and variable lags between monetary policy and the real world.

I've always thought that the primary objective of a central bank that chose to adopt interest rate targeting as its method for implementing monetary policy (as all major central banks have done) should be to pick the interest rate that leaves the market indifferent between buying government bonds and tangible assets such as gold and real estate. In practice, this could be described as a type of gold standard: the central bank should simply raise or lower interest rates (by selling or buying government bonds) in order to keep the price of gold within some specified range. Shrinking or expanding the money supply in this fashion would automatically keep the market indifferent between buying financial assets and tangible assets, because it would avoid monetary excesses or deficiencies, and thus deliver an essentially zero rate of inflation. Such a policy would inevitably lead to a very low and stable interest rate environment. And that, according to supply-side tenets, would be the best way for monetary policy to stimulate the economy.

If the Fed were to do this today, what should its target price for gold be? That is a question that has no definitive answer, but I'm going to guess that it should be somewhere in the $400-500/oz. range. As it happens, the real price of gold over the past 100 years has averaged about $450. If $450 is the price of gold that corresponds to "neutral" or zero-inflation monetary policy, then gold today is trading for a premium of over 100%; buying protection against inflation in the gold market is very expensive. Put another way, the Fed is going to have to continue to stand pat, and/or inflation is really going to have to accelerate just to keep gold from falling. If the Fed were to tighten policy sooner than expected, and with vigor, gold prices could tumble dramatically.

I'm not arguing against an investment in gold today, since rising gold prices seem to be the path of least resistance for now, considering that with one single exception (the Australian central bank), the world's major central banks have given every indication that a tightening of monetary policy is unlikely in the near future. My point is that buying gold is a very risky proposition now that it is trading at these lofty levels. In a best-case scenario for gold, we might see it revisiting its 1980 high in today's dollars (about $1800), but in a worst-case scenario it might fall back to $400. That's a very lopsided risk/reward proposition (aka an extremely speculative investment).

What could drive the worst-case scenario? Gold prices are extremely vulnerable to the mere suggestion that the Fed might begin reversing its liquidity injections. Gold prices are also very vulnerable to signs of stronger-than-expected growth, since the market can easily put two and two together and realize that a stronger economy means an earlier and more aggressive monetary tightening.

And while on the subject of vulnerable gold prices, these same arguments hold for T-bond prices. Yields on Treasuries are very low, mainly because the Fed is expected to be very easy for a very long time. Even the slightest change in those expectations could result in a sharp rise in Treasury yields, and a significant decline in T-bond prices.

16 comments:

But what if when the Fed does begin to tighten, it takes another slow, long, and predictable path of 25bp per meeting increase in rates similar to Greenspan?

This type of rate delivery does nothing to stop the rise in financial speculation because the path is predictable with low vol making the probability of "popping" bubbles via monetary policy rather low.

In one sense, the stability and transparency the Fed wants to instill in the market, becomes the very problem it has to overcome.

I am not doubting your observation, but as with the past bubble, it will require a far more aggressive Fed to get ahead of the curve.

This is not really what their doctrine is designed to do. For some reason, considering the current climate, I cannot foresee a Fed stunning the market during the eventual rate raising cycle.

Thank you, that was great background. It is fascinating to hear all the gold commercials (mostly on talk radio) these days. It almost seems criminal how they promote gold as an investment. Of course it's not criminal any more than many other investment vehicles, such as bad mutual funds in expensive 401k plans.

I cannot understand the reasoning of 'investing' in gold. At the end of the day it's just speculating on how others will speculate on gold prices. That is too fickle a game.

Public: your points are well taken. I can only say that "this time is different." The funds rate will start from a base of zero (effectively). Gold and commodity prices are up hugely. The economy is in a V-shaped recovery. The Fed has not choice but to withdraw massive amounts of liquidity from the market just to get back to neutral (i.e., $1 trillion). I think the market is going to force the Fed to move faster than it did the last time.

randy: The more commercials for gold on TV that I see, the more nervous I would be if I held gold. It's like when you hear your secretary or your barber talking about buying stocks that have already surged--you have got to begin to worry. The gold trade makes sense intellectually (i.e., the Fed is extremely easy and they are likely to mess up the tightening), but it is also a very very crowded trade. Caveat emptor.

I guess, I am still struggling with how the US will pay back the massive debt - -doesn't that fit in here somewhere? Either higher taxes or monetize the debt? Both of which don’t speak well for an economic recovery - -and subsequent rising interest rates by the Fed.

Scott, how true (re: gold commercials). I was in line at a Phoenix Starbucks in 2006 and heard the Barista telling a friend waiting for their latte that she just bought a THIRD condo and how great real estate was as an investment.

I remember turning to my wife and saying that real estate was just about done rising in price.

There may be a lot of commercials on Gold (because most are WAY overcharging for it--commissions), but ask any financial advisor how many of their clients own gold; and for those who do, what percentage of their portfolio is in metals.

Both answers will be a tiny percentage!

You can't double the monetary base and put us on a path to double the debt in the next 8 years and expect the dollar to hold it's value.

In the 30's, FDR confiscated gold in order to spend more and devalue. Today, they don't need the gold...they just print more.

When govt wants to spend more, they can tax it, or print it. Either way, we the people end up with less in our pockets. Scott, I see a recovery from the depths, but not a return to solid growth. I see a major, frontal assault on this country from Obama & Co. An assualt on free markets, capitalism, capital, the dollar, production, liberty, and on and on.

This time IS different.

I've been buying gold since last year ($720 oz) and buying Aust, Can, Switz bonds (especially the Austrailian). The dollar is going lower. Much lower.

Scott&Fran: The federal deficit is almost unprecedented, our national debt is soaring like never before since WW II, and our fiscal policies are simply abysmal, but all is not yet lost. Believe it or not the economy can handle deficits and debts of this magnitude. But of course, not forever. I figure we have a quite few years yet to put things right before the sky falls (don't tell that to the politicians though!). Japan and Italy have had worse deficits and debts (relative to the size of their economies) than we have now for quite a number of years and they are still standing.

Scott,Great post, and thanks for fitting it to your other themes. I share your skepticism for interest rate targeting and your belief that a gold price target, not a Fed Funds Target, is the best alternative. I think under such a system, the market would help the Fed. If the Fed announced their gold target, the market would get them there orderly and quickly.I agree the gold target number under such a Fed system is impossible to determine. They almost have to be arbitrary. My arbitrary suggestion is the 1000 day moving average of around $750/oz. I don't understand the idea of the "real" price of gold. Nothing is more real than gold, and dividing it by a price index seems inappropriate.

In the first paragraph of your article, John B. Taylor’s book “Getting Off Track” mirrors your statements. Matter-of-fact, Taylor gets right to it on page 3 of his book. That easy money set the stage for all of the consequential cascading unintended consequences aka Financial Crisis. Taylor’s book is only 100 pages long. It’s a quick read and very informative.

Regarding the comments posted about the amount of “Gold Commercials”, heard the following theory regarding “commercials“ in general:

(1) as the economy goes into recession, prime advertisers cut their ad budget as a component of over all cost cutting,

(1a) demand for commercials/ad space falls hence price falls,

(2) enter a series of advertisers akin to the old Ronco ads. Ads you generally see at 3 am in the morning,

(3) the lower costs cause a flood of advertisers to enter prime time that are generally non prime time players,

(4) when these non prime time players begin to be migrate back to their late night time slots, then its an indicator of economic recovery as traditional prime time advertisers have experienced expanding demand, expanding revenue, expanding ad budgets, and the demand for ad space rises causing ad space price to rise.

brodero: I generally assume that gold moves in advance of other commodities, and that reflects my belief that monetary errors (which influence liquidity creation) tend to be reflected in other prices with a lag. Copper has a monetary component and a growth component, and separating the two is beyond my abilities. But in general I would expect that a rise in the ratio of gold to copper prices would be a signal that monetary policy was accommodative.

Whether accommodative monetary policy leads to more growth, however, is another question entirely. In the current context, I think easy money has been a good predictor of growth, since part of the reason growth slowed down last year was the fear of a big monetary deflation. Now that we have eliminated that problem, the economy can "catch up" to where it otherwise would have been, and that means more growth.

The ratio does appear to be on the high side of historical trends these days, so I think that means more good news ahead for growth.

REW: Since gold does a good job of maintain its purchasing power relative to other things over very long periods, it seems to me that the real, inflation adjusted price of gold should evidence mean-reverting tendency around some value, which in my example I'm guessing is $450. That would to me represent the "real" value of gold, the value that we would see if inflation were low and stable and the Fed were not making any monetary mistakes.

Jeff: I can't argue with what you're saying. I am probably more optimistic than you, however, since I see the potential for things to change for the better. There is lots of pushback developing, as the people get more and more uncomfortable with Obama's spend-and-spend and tax policies. I just can't imagine he can continue with this agenda. The market seems very depressed, believing that he will continue, but I keep thinking of how surprised the market could be if and when the political agenda changes for the better.